The votes are in: It's the low-cost party in a landslide
21 October 2016 | Topical insights
Commentary by Jeff Johnson, head of investment strategy for Vanguard in the Asia-Pacific region.
United States presidential elections have a way of putting me on the spot. As an American working in Australia, I'm regularly asked for my thoughts about the candidates, who will win, and how the markets will respond if one candidate or the other prevails.
While I prefer to stay out of politics, I understand the fascination. From our curious election rituals (why do US politicians always seem to be kissing babies?), to the long campaigns, to the frantic 24-hour news cycle, it can be difficult to look away.
Meanwhile, a very different kind of vote is quietly taking place. It's the choice more and more investors are making each day as they flock towards low-cost mutual funds and exchange-traded funds. Ultimately, it's the outcome of this decision that may have the greatest impact on investors' long-term returns.
In this other "election", the low-cost "party" is challenging the high-cost status quo. The low-cost party platform is simple: Don't assume that you'll get more if you pay more. While you can't control the markets, you can control the amount you pay to invest. Lower costs allow you to keep more of your returns, which can help you earn more over time.
It's a compelling message, and it's backed up by data. In the chart below, the bars represent the 10-year annualised return gap between the lowest- and highest-cost funds in various asset- and sub-asset classes.
Over time, lower costs have meant higher net returns
Difference between median funds in the lowest- and highest-cost quartiles
Note: Data are as at 31 December 2015 and include US-domiciled funds only. Past performance is not a reliable indicator of future results. Sources: Vanguard calculations based on data from Morningstar, Inc.
The next chart compares net cash flows of low-cost equity funds with those of their higher-cost counterparts. Since 2012, the "vote" hasn't even been close. The story is similar for fixed income investments. In 2015, about 93% of net cash flows into taxable US bond funds went to low-cost options.
Investors are choosing low-cost equity funds
Relationship between net cash flows (in billions of US dollars) and expense-ratio quartile of US equity funds and ETFs
Notes: Expense-ratio quartiles were calculated annually. Each quartile represents 2015 asset-weighted average expense ratios, determined by multiplying annual expense ratios by year-end assets under management and dividing by the aggregate assets in each quartile. Includes US-domiciled funds only. Data are as at 31 December 2015. Sources: Vanguard calculations, based on data from Morningstar, Inc.
What's the takeaway?
First, low-cost investing isn't just a quirky preference of US investors. It's an idea that's grounded in theory and borne out by real-world results.1 Second, the trend towards lower costs may have begun in the United States, but it's taking hold elsewhere. Changes in government regulations, the introduction of indexed ETFs and the strong long-term performance of low-cost investments have all helped the trend become a global phenomenon.
Political votes have consequences. June's Brexit referendum is a reminder of that. Even so, it's important to keep elections in perspective and focus on the aspects of investing you can control. Casting your vote for the low-cost party is a great place to start.
1 For more on this topic, see our paper The case for low-cost index-fund investing
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